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David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures. Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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Today Heidi Moore interviewed me for NPR Marketplace. I won’t give away what it is about, but I will tell you two things:

If I am on Marketplace, it will be on Friday or Tuesday.

There was a point in the interview where she stumped me. I’m usually pretty able to think on my feet, but when she asked me “Volatilty: can you explain that in language that a teenager could understand?” I choked up, did my best on short notice, and gave what I later viewed as a lame explanation, but as I said it, my heart sank, because I realized I was not clarifying anything.

So, after the talk (It was really good to meet Heidi voice-to-voice for the first time), I took a walk outside and pondered. Then the analogy struck me, and here it is:

Imagine you are driving down a well-engineered smooth road with gradual turns, modest traffic, and no bad weather, and you are going 60 miles per hour. This is easy. There is no volatility here. That is what an average retail investor hopes for, and rarely gets.

Now consider a road that is not so smooth, with significant and frequent curves, significant traffic, and now and then it is raining hard. That is a difficult situation. This is similar to what the market is normally like, with all of the volatility (high variation of results). Maybe you can’t do 60 MPH in that environment, but something less. Those who recognize risk must run at a slower speed or risk accidents.

Now think of someone without special skills who dares to drive the easy road at 100 MPH. He might not think it so hard, and might think he is quite a driver doing so. So it was for equity investors in the ’80s and ’90s; conditions were uniquely favorable, and average investors thought they were hot stuff.

Now think of someone without special skills attempting to do the hard conditions at 100 MPH on average. Odds are they wipe out, or even die. You can’t fight physics, or can you?

Okay, now think of a highly trained driver with a special car that is able to handle the hard conditions, and can do it at 100 MPH on average, most of the time. It doesn’t work all of the time, because there are things no one can catch — extra slipperiness, a bump in a particularly bad place that leads to an overturned car.

Finally, think of the trained driver with special car told he must average 150 MPH over the hard conditions course once. He dies on the first try, destroying the car. Several other trained drivers try with identical cars. They all die, and the cars are destroyed. Eventually, you can’t get anyone to try the hard conditions course at 150 MPH.

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In my analogy, the difference between the hard and easy course is volatility: how rough/variable are conditions. Leverage is represented by speed. Any course can be completed, but there is a maximum speed for which a course can be completed without disaster. No surprise that those who are overly aggressive in investing frequently fail.

Now for the final tweak: imagine that you have no map for the hard course, it is new to you, no GPS, nothing to aid you in the driving. That is what the markets are like. As I often say, the markets always have a new way to make a fool out of you. How fast could you go? How fast could the trained driver with a special car go?

This is why I urge caution in investing and avoiding leverage. Investing is tough enough without trying to earn something beyond what the market can bear. I encourage safety first, after that, look for best advantage.

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This is a short book that in some ways is a summary of Reinhart and Rogoff’s greater work This Time Is Different: Eight Centuries of Financial Folly. Think of it as an executive summary in book form. How short is it? Less than 160 pages, but in terms of text there’s less than 40 pages of text in this 6″ x 9″ book, so it’s a fast read.

Graphs occupy the remainder of the book, with the latter two-thirds of the book going nation-by-nation, allocating 1-3 pages to each, showing Debt/GDP, and the various sorts of financial crises they have faced.

Main Findings

1) When debt to GDP ratios get above 90%, growth rates fall by 1%.

2) Emerging markets fare worse than developed market on point #1.

3) There’s no relation in the short run regarding public debt and inflation in developed nations.

Other Findings

1) Many nations default continually… I allege cultural problems, but I am willing to be corrected.

If you enter Amazon through my site, and you buy anything, I get a small commission. This is my main source of blog revenue. I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don’t change.

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I’m here this evening to review another excellent book on risk control by David X Martin.

This is a difficult book to review, because if I describe what happens, I end up spoiling the book. This is a small book, and I read it in less than an hour.

This book came into existence because the author had a hard time explaining risk to the family of a friend who had died, and then his own family. He wanted to come up with a simple way to describe risk to those who don’t know markets. His tool was using common animals in a forest to explain risk, because their behaviors mimic those of different sorts of people as they face risks, or decide to ignore risks.

One thing I appreciate about the book is that it takes an ecological approach to risk. My view is that markets are not like physical systems, they are like ecological systems.

Risk can never be eliminated, but it can be prepared for and managed. I think that is the main message of the book.

For most of you reading me at Aleph Blog, this book would be fun for you but not necessary for you. But consider some of your friends and family members that are not as sharp as you. Personally, I am planning on having my wife and kids read this book. Living with me, they pick up a lot, but this book is a clever way to teach risk management without making it seem like it is being taught.

To me the real use of this book is to teach less market oriented friends, family, and children about risk. This is a small, simple but powerful book.

It’s a little book, and it is a very good book, but 15 clams for such a small book? I would have priced it at $10 or so.

Who would benefit from this book: This book is designed for beginners and intermediate investors. Get it as a gift for friends who you think are taking too much risk, and don’t get that. Or, use it to educate young people about risk. If you want to, you can buy it here: The Nature of Risk.

Full disclosure:The author asked me if I would like the book and I assented.

If you enter Amazon through my site, and you buy anything, I get a small commission. This is my main source of blog revenue. I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don’t change.

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I am going to say something that I rarely say: I am grateful that this book was written. Why am I grateful?

It highlights the idea that people, even really bright people, do not behave rationally, but imitatively — they follow recent price action — they mimic.

It validates the concept of a “crowded trade,” one that offered high returns in the past, may presently offer low returns to a “buy and hold” investor, but will deliver negative returns in the near future, because the holders of the trade are relying on the trade to deliver positive returns in the short run, and will bail if it doesn’t happen.

It points up the nonlinearity of markets, and invalidates the efficient markets hypothesis; it validates the concept of the boom-bust cycle both in micro and macro.

It teaches us to not take on too much debt, even if we are really, really smart. We aren’t as smart as we think we are.

In short, it sums up a lot of my philosophy at The Aleph Blog. Real risk control thinks long term, and considers what will happen if liquidity dries up. Real risk control knows that large positions in any asset relative to the market must be regarded to be “Buy-and-hold” regardless of what your trading intentions are. False risk control assumes that markets always function, and that your relative size versus the market does not matter.

The author of the book has led a storied life. He was a quantitative analyst hired to work in risk control for Long Term Capital Management [LTCM] near its inception, and continued with them through the failure. After that, he worked for Rydex, built FOLIOfn, and worked for the Bank of International Settlements, and Schroders. He now works as a professor of finance at the University of San Francisco, after having gotten a PhD from MIT. He knows the markets both practically and experientially, like me, though he is better than me.

LTCM is a great example of what happens when some really smart guys find clever ways to make money in the markets, and then overplay them. The trade that has a buy-and-hold yield of 10% is genius. When it is 8% it is bright. At 6% it is average, why are you playing? At 4% it is dopey. But what happens when your trade gets big relative to the market? The rules change, much like JP Morgan recently. When you are big enough that you are moving the market as a normal practice, that indicates danger. You have become the market, and are distorting it. It will eventually come back to bite you, as JP Morgan recently learned.

The failure of LTCM may have been the template, but the author goes on to explain other disequilibrium situations such as:

The quantitative equity panic of August 2007

The failure of Bear Stearns.

The failures of Fannie and Freddie (free money brings out the worst in all of us)

The failure of Lehman Brothers.

The failure of the banking system both in the US & Europe

The failure of LTCM progeny in 2008 (no, we don’t learn)

The Flash Crash

The failure of the Eurozone, so far. (It is performance art. How can we create the biggest failure ever? We will eclipse the Great Depression! Oui! Ya!)

I’ve written about most of these, and I can tell you the author does a good good job. Aside from that, he took time to interview primary sources as to their own view of the events that happened, particularly at LTCM and its progeny, and it adds to what we know about the crises that he wrote about.

People need to understand that crises are a normal aspect of markets. Until you understand that crises are normal, you will always take too much risk.

This is an excellent book; buy it and avoid losses.

Quibbles

In the beginning he got the name of Cramer’s firm wrong.

I would have eliminated the appendices if I were the editor, the audience that can benefit from the math is too narrow to be worth printing it in the book. Better you should put a PDF out on the web, and put out a slimmer book.

Full disclosure:The PR flack asked me if I would like the book and I assented.

If you enter Amazon through my site, and you buy anything, I get a small commission. This is my main source of blog revenue. I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don’t change.

Buffett is different, because he grew as an investor and as a businessman, and usually made the right moves over a 50+ year career. When you don’t have a lot of assets, and few people are doing value investing, you can do amazing things with special situations, and being an activist investor. In 1967, Buffett had control of a textile company named Berkshire Hathaway, when he used the resources of the company to purchase some smallish P&C insurance companies, National Indemnity and National Fire and Marine Insurance.

This brings up the first way that Buffett is different than most investors. He understands and invests in a complex industry, P&C insurance. He begins to realize that it can be used as a platform for greater investing. As he sees that potential, he buys half of GEICO in the 70s, before buying the whole company in 1994.

This brings up the second way that Buffett is different than most investors: Buffett was willing to buy whole companies, not replace management for the most part, and operate them. Buffett limited himself to being the wholly-owned company’s board, asking questions on management competence, and redirecting free cash flow for the greater good of Berkshire Hathaway.

That brings me to the third way in which Buffett is different than most investors: He analyzes cash flow streams from investments, and buys shares in companies, or the whole company when they offer a reliable high prospective free cash flow yield. And it brings me to the fourth way Warren Buffett is different than most investors: Buffett does not diversify, particularly in the early years. He plays for best advantage. Buffett views investing through the lens of compounding cash flows, and does not pay much attention to the market as a whole.

In my opinion, it is a worthy use of time (but don’t neglect your family) to read through the annual letters of Berkshire Hathaway. If you do that, you will get a sense of a clever businessman who would invest for best advantage. His tactics shifted over time, but he was always looking to compound free cash flows at the best possible rate.

I’m going to hit the publish button now, but I will finish this in part 2.

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What does Washington, DC care about more — people or corporations? Do you have to ask? DC favors corporations, and all three branches of the government support this. Both parties favor this. Why is this so?

The corporations, and those that own them are a more effective means of raising funds to maintain their hold on the offices that the occupy. Beyond that, there is an attitude that economic policy needs to be carried out through laws that address corporations.

So whether you come from the t-party, Occupy, or someplace else, you might harbor resentment against the status quo: big government in league with big corporations, and wealthy people.

I wish it weren’t so, but the Constitution takes a back seat to “pragmatic” concerns, especially when a “crisis” happens. It should not be that way, but that’s the way it is.

So, what if you drop an idealistic guy, the author, Neil Barofsky, into the job of watchdog for the TARP? [SIGTARP: Special Inspector General of the Troubled Asset Relief Program] He objects to the uncontrolled nature of how money is being handed out to banks, with few checks as to how the money will be used.

Now, the author could have made a stronger argument. The FDIC, where does it pump in cash to failed institutions? They protect depositors — that’s the lowest level of the capital structure. But where did the TARP add capital? At the highest level of the capital structure; they bought stock and warrants.

Constitutionally, the government has no authority to own corporations. Further, even if the government had that authority, if it was trying to preserve the soundness of the banking system, the proper way to do it would be to make senior secured loans. That would guarantee the banking system, but let the common and preferred stockholders, and bondholders go broke before the taxpayer coughs up the first dime.

As it was, the author found himself adrift in DC, cleverly fighting to bring some rules to what was a giveaway to the banks, many of which did not need the bailout, and certainly did not want the limits on executive pay. He found that DC was a place where the bureaucratic government fights itself. No one wants to look lazy or foolish, so when someone alleges a crime against a party that another branch of the bureaucracy is supposedly investigating, they fight back. Applying the principles of Peter Drucker, our government could be smaller, and more effective — there would be fewer turf wars.

Were the Bailouts Wrong? Did they Fail?

The author makes the case that the bailout has failed. When he says that he is not saying that the bailout as a whole lost money. (I would note that the bailouts have lost money on the home if you include Fannie and Freddie, the auto companies, along with all of the financial institutions including AIG.) He is saying that the problem of too big to fail banks has not only not been solved, is actually gotten worse since the crisis. The big five banks now have around 50% of the deposit base in US. “Too big to fail” is a problem unsolved that still threatens our financial system. This problem is solvable; the US government broke up AT&T (then allowed it to recombine again). Interstate branching could be limited, or ended.

The second problem with bailout is that engenders moral hazard. Because you have done it once, it would be expected next time, which when the financial system once again enters a bull cycle, the bankers will know that the federal government has its back and will not be inclined to limit risk to the same degree that they otherwise might.

The third problem with the bailout is that it was uneven. A logical question for any person harmed by the crisis is, “Where’s my bailout?” Even if bailing out the banks in order to preserve financial systemic integrity was needed, there were other ways to do it, such as being lender of last resort at a penalty rate, or giving vouchers good to reduce debts to every household in America. Particularly that last option would have been viewed as fair by the American people. That could have saved some of the pain felt by those with mortgages, and help the creditworthiness of loans at the banks. Instead, the Obama administration created programs like HAMP, which did little good for most, and actually harmed some.

The fourth problem with bailout and monetary policy that accompanied it was that it was a large transfer of wealth savers to banks. It doesn’t do much for the economy, if the banks have zero cost on their deposits, and all they do is invest in ultrasafe securities, clipping a small, but safe profit.

What was it Like to be There?

More often than not, the Treasury Department did not want to have the Special Inspector General interfering with their plans. There was a lot of stonewalling, and nondisclosure of pertinent data. It got fairly contentious at times, and often required members of Congress to intervene on behalf of SIGTARP. The relationship probably got worse over time, because those working at SIGTARP knew that they would have no influence, no changes would be made, unless they convinced the media that something was wrong, and thus prodded Congress to push for change at Treasury. The worst that that could happen would be that the President would fire the Special Inspector General, and appoint a new one.

Another part of challenge was realizing the need to build a talented team of lawyers, analysts, PR professionals, etc., to do the work analyzing how TARP funds were being spent, and write reports that would grab attention, and change the terms of the political debate.

That challenge was made more difficult by a lack of adequate facilities. The initial staff was relegated to some pretty poor accommodations at the Treasury building. I met with the SIGTARP staff over the AIG bailout in June of 2010 over a paper that I wrote that exposed aspects of the weakness at the domestic insurance subsidiaries. (For Amazon readers, there is a link to my report at my blog.) The accommodations that they had were some of the poorest I ran into in DC.

I know from personal experience that the US Treasury was sensitive to any criticism of the TARP. At the first blogger summit at the Treasury, the officials were prickly over any questioning on the topic. It did not help that GMAC got another dollop of cash that morning. (links here, and here)

There were some ugly controversies. One of the SIGTARP reports noted that if every potential program had been fully tapped the US would have expended $23.7 Trillion. The report caveated that figure heavily, but it was seized upon by Republicans for partisan advantage. They took a lot of flak for totaling figures that were in some sense apples and oranges.

On page 190, the question from Democrat Stephen Lynch to Tim Geithner, “Why didn’t he try harder to cut a better bargain for the American people?” was never answered by Geithner. Truth, Treasury was making it up as they went, with counsel from money managers and banks, which left the US Treasury vulnerable to those more technically proficient at finance who had at least some degree of conflicts of interest.

One more limitation of SIGTARP, they had no ability to bring cases – they had to convince the Department of Justice or another prosecutor to take action. That brought another level of negotiation and bureaucratic infighting.

The end came for the author after he realized that the TARP was winding down, and he was tiring of the Washington scene, and the corrosive effect it was having on his own character.

That leaves me with one closing question: What good did the author and his team do? In one sense, not a lot. The current financial regulatory environment post-Dodd-Frank continues business as usual with a more complex bureaucracy, with likely more infighting between competing regulators. My view is when many are responsible, no one is responsible… that is certainly not the fault of SIGTARP, but we are probably in a worse regulatory environment than prior to the crisis.

That said, SIGTARP gathered data on the TARP, which led to a decent number of small and medium-sized fraud cases, and constrained the open-handed nature of the US Treasury toward financial companies, which could have result in a lot more fraud, and/or higher costs to the taxpayer.

Quibbles

Small mistake on page 173, where the author mentions PNC acquiring City National Bank instead of National City Bank.

The book reads a little disjointedly. It is mostly chronological, but topical by chapter, so sometimes it feels like two steps forward, one step back as far as the time flow goes.

Who would benefit from this book: This book will benefit anyone who wants a first person account of what it was like to be the Special Inspector General of the TARP. It is also for those who want to see how dysfunctional politics can be in DC, and how resistant the Treasury Department was to any limits on their autonomy. Finally, it shows how difficult it is for anyone to change the system in DC. The author survived in DC for 2+ years as a change agent; that’s difficult enough, but he is gone now, though SIGTARP soldiers on. If you want to, you can buy it here: Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street.

Full disclosure: I asked the author to send me data on his PR flack, who I asked to send the book to me.

If you enter Amazon through my site, and you buy anything, I get a small commission. This is my main source of blog revenue. I prefer this to a “tip jar” because I want you to get something you want, rather than merely giving me a tip. Book reviews take time, particularly with the reading, which most book reviewers don’t do in full, and I typically do. (When I don’t, I mention that I scanned the book. Also, I never use the data that the PR flacks send out.)

Most people buying at Amazon do not enter via a referring website. Thus Amazon builds an extra 1-3% into the prices to all buyers to compensate for the commissions given to the minority that come through referring sites. Whether you buy at Amazon directly or enter via my site, your prices don’t change.

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This occurred to me today, and so I want to toss it out as an idea, even if I never get to work with it. What percentage of stocks are covered by 13F filings? I bet it is pretty high.

Here’s my idea: using the 13F filings, we segment holders into traders (“weak hands”) and investors (“strong hands”), based off their level of turnover. If my ideas are right, the stocks held by the “strong hands” investors will do better over time.

For anyone with access to an easily accessible version of a 13F database, this is a project I would be willing to take on. If you have interest, e-mail me. Thanks.

As I was considering the Dow Jones Industrial Average, I considered how much influence IBM has relative to an equal-weighted index. It has 3.48 times more influence that the average. Then I considered the lack of influence of Bank of America [BAC], whose influence is 86% less than the average. It may be up 47% YTD, but it budges the index but little despite its large market cap.

Such is life in a price weighted index that was designed to work around 1900. Add up the prices, divide by a number, and there is the index.

Even an equal weighted index would be more realistic. But what if we created a market cap (actually float) weighted DJIA, like the S&P 500?

At this point, Exxon Mobil would be the heavy hitter, and small Alcoa the baby. Prediction: Alcoa and The Travelers will leave the Dow, to be replaced by Oracle and Berkshire Hathaway “B” shares.

Wait! Oracle?! Why not Apple or Google? Their share prices are too high, and the DJIA is too messed up already. If Bank of America wanted to help the Dow, they would do a 1-10 reverse split, as should Alcoa, should they stay in the Dow.

The DJIA is a historical accident that has more then outlived its 15 minutes of fame. It does not represent the market as a whole. The best that Dow Jones News Corp could do is remake it as a megacap market cap weighted index. Then it might have real punch and validity. Call it the News Corp Industrial Average [NCIA]. What might that index look like?

Now, that said, give the folks at News Corp Dow Jones some credit. They created a flawed Behemoth index, but it is the only widely quoted Behemoth index, and my adjustment of it only improves the market capitalization by ~40%. That said, capitalization-weighting makes it a much more rational index, and so I call upon Dow Jones News Corp to make the changes that the sentimental at Dow Jones never would, and turn the DJIA into the NCI. Not an average, but a real Behemoth index that measures the performance of the largest companies of the US, which comprise ~30% of the total market capitalization.

There is the challenge, and taking it on will benefit investors for the next 100 years. Are you man enough to take it on, News Corp?